After an extremely difficult 12 months for sharemarkets – both in Australia and globally – equities are starting to show signs of a return to relative stability. Donald Williams, Chief Investment Officer at Australian equities manager Platypus Asset Management shares his thoughts as the sharemarket shows signs of recovery.
A market rally since the lows of March has continued to give investors cause for optimism. The main question on everyone’s lips is, is this rally for real? The truth is, we probably won’t know the answer to this until after the event. However, it’s helpful to look at some of the historical data about bear market rallies (see table below). They show that these rallies can be very strong and provide handsome returns to investors who can hold their nerve. In many instances, the losses in a bear market have been all but wiped out by the returns from the bear market rally.
All Ordinaries Index of Bear Markets
When markets do start to rally – particularly after savage falls such as those seen in 2008 and early 2009 – there are usually several stages that investors go through.
The first is the ‘denial’ stage. Investors are so exhausted from successive months of large negative returns, and the general pessimism, that they don’t want to believe any positive news. At this time, any view that puts forward a more optimistic stance is often scorned and even resented.
The second phase, following on from denial, is the ‘capitulation’ stage. Those who were originally sceptical start buying during the lows, and reduce their underweight position. If the market stays relatively strong and there is no bad news or shocks to the system, more people start to invest on ‘down days’. As a result, the downside becomes limited as the market consolidates further. Those still sitting out the market start to feel pressured to re-enter or miss out.
The final phase of a rally is often that of ‘fear’. This is driven by a fear of missing out, and investors become convinced that the bull market has started again and it’s time to buy. Those who remain sceptical find the tables are turned and they are now the ones ridiculed.
It seems likely that we are now at the beginning of the capitulation phase, where the pessimists are still outnumbering the optimists but the number of optimists is growing. Cash levels and underweight positions are high and, as long as there are no shocks out of left field, there is a good chance that the rally will progress to the next stage where dips in the market get bought, limiting the downside, and the markets grind up from current levels.
If this continues and we progress to the ‘fear’ stage, the market could put on a further 20 percent from what most would consider fair value.
Source: Westpac and Platypus Asset Management
It’s worthwhile sounding a note of caution here. It is likely that the six months to June will be much tougher for the majority of companies in Australia in comparison to the six months to December 2008. Equally, the December half of this year could be difficult, and it won’t be until the end of 2010 that we can realistically expect to see growth in profits and dividends.
On the whole, however, the stimulus packages in Australia, combined with lower interest rates, are doing their job. For instance, retail sales have recovered since November last year and we would expect to see the retail sector achieve a three to five percent growth rate which is all high quality franchises need to keep growing their earnings.
Overseas, China has generated some positive data recently, seeing the Australian dollar approach 80 US cents. If the Chinese economic recovery continues, it will be very positive for the Australian economy and recovery in earnings could in fact occur quicker than the market is currently anticipating.
We have also seen an improvement in US data, the most significant of which was the first material increase in consumer sentiment since the recession began. While we expect the economic data to be less negative for a few months, it will inevitably plateau and cease to be a helpful factor. In the meantime we look forward to further gains as the market reprices back towards fair value.
In Australia, the market recovery continued throughout April, with every sector posting a positive return. Despite several profit downgrades and capital raisings, the market traded consistently well through the month. The pattern for the market since the March low is consistent with previous recovery periods, with investors shrugging off bad news, preferring instead to look forward to (presumably) better economic conditions in six to twelve months’ time.
As a result, volatility (measured by the Volatility Index) has declined since its peak in October/November last year, although it remains at historically high levels. I believe that the period of extreme volatility is now over; however it is unlikely we will return to a low volatility environment any time soon. Federal governments and central banks around the world have taken action to get markets operating more or less normally again, and as a result we should settle into a more predictable pattern.
The recent recovery was led by financial stocks which outperformed substantially up to the end of March. During April, they were comparatively speaking the ‘worst’ performer, only increasing by four percent; however, this was due to the rest of the market catching up rather than any problems in the sector itself.
We are starting to see good value emerging in the banks as the outlook for their earnings becomes clearer. At the moment a deep recession appears unlikely which could mean the bad debt cycle is peaking now. We will need to see the full year results for the banks before we can be sure this is the case.
A sustained economic recovery could see bank stocks perform strongly as people become less concerned about bad debts and focus on the banks’ strengthened position. Other companies and sectors that could lead any recovery including transport companies such as Qantas and Toll Holdings. Media could also perform well as the sector hasn’t yet participated in the rally. In particular, Fairfax could double in price if investors felt the economy was genuinely picking up speed.
In many ways, the market is now ‘marking time’ as more information becomes available to investors and the true strength of the rally is tested. It is a very good sign that a number of companies have continued to trade strongly, even make gains, despite issuing profit warnings in recent months.
Donald Williams is Chief Investment Officer at Platypus Asset Management, an Australian equities joint venture partner of Australian Unity Investments
MAY 2009